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Is the Party Over for Junk Bonds?

High-risk high-yield bonds a.k.a. speculative bonds or junk bonds are those rated below BBB- by Standard & Poor’s rating agency. The default rate for junk bonds has been low at about 3.2% recently versus the historical norm of 4.5%. The outlook for the default rate is favorable in the near term.

Junk bonds have boomed following the Fed’s decision to continue with its loose monetary policy with $85 billion in monthly asset purchases. In fact, quantitative easing, accompanied by rock-bottom interest rates, has been accused of creating asset bubbles in places such as the treasury bond and the junk bond markets.

With investors chasing higher yield in the wake of low returns on other assets, high yield issuers raised a record quantum of debt in 2012. Fund raising companies have frequently used the proceeds to refinance higher interest-bearing loans. Some of the money ended up with private equity firms, such as Bain Capital, who borrow for leveraged buyouts and then burden the company with debt. In any case, there is no doubt that the boom in junk bonds has ensured access to capital markets for even those companies with the lowest credit ratings.

The chase for yield has driven down the yield on junk bonds to record lows. In fact, the interest in such bonds has been so great that some mutual funds have even refused to take new investors. Junk bond yields recently fell below 6% for the first time (giving them about 500 basis points spread over U.S. Treasury bills). From a historical perspective, junk bond issuers have paid about 10% in interest charges. (It is noteworthy that while yields may currently be low, spreads are nowhere near their historical bottom.)

After several years of tidy returns, returns from junk bonds came to over 15% in 2012. The sharpest appreciation has been in the lowly CCC rated paper. With good returns in the period following the financial crisis in 2008, market mavens wonder if there is much room left for capital appreciation or whether these bonds are to be held as a coupon play only.

Risks to the high yield market include a cyclical rotation into equities, firmer interest rates or a weaker economy, which would increase corporate default. Even without any recession, there is risk in the sense that should earnings take off again, then investors may bail out of debt to enter the stock market. Furthermore, investors face potential losses in case of callable bonds.

T. Rowe Price High Yield Fund gave an annual return of 15.2% in 2012 and a 3-year return of 10.8%. Prominent leveraged plays in this fund include Sprint Nextel Corp. (S - Free Report) and CIT Group Inc. (CIT - Free Report) .

The Putnam High Yield Advantage Fund gave an annual return of 15.1% in 2012 and a 3-year return of 10.4%. Noteworthy leveraged plays in this fund include HCA Holdings, Inc. (HCA - Free Report) and SLM Corporation (SLM - Free Report) .

Besides high yield mutual funds, investors may also select from the following two high yield bond ETFs, both of which are well tracked, offer high liquidity and may be considered to be a proxy for the junk bond market. The iShares iBoxx $ High Yield Corporate Bd (HYG - Free Report) and SPDR Barclays High Yield Bond (JNK - Free Report) are well known junk bond ETFs.

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